For more information about Vanguard funds, visit vanguard.com or call 877-662-7447 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss.

Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. Stocks of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.

All investing is subject to risk, including the possible loss of the money you invest.

In most areas of life, it’s often best if we ignore the little things that we typically can’t control, such as traffic on the way to work or rain on your wedding day. However, in my opinion, you should sweat the small stuff when it comes to investing, because seemingly little details can meaningfully impact your bottom line.

In recent years, many people have become aware of the detrimental impact of higher costs on their investments, as evidenced by the significant cash flows going into low-cost mutual funds and ETFs.¹ Equally important for retirees spending from their portfolios is the tax impact on annual spending because of spending order, which is simply the order in which you withdraw money from your accounts. Like low-cost investing, understanding how to efficiently spend from a portfolio can help fund a better life for tomorrow.

For most investors, once retired, spending needs persist even though salaries may not. While pensions, Social Security, and other income sources may provide for some of your retirement income needs, they likely don’t provide for all of them, requiring you to spend from your portfolios. So then the question is, “how?”

Complicating matters is the fact that many investors have one or more “retirement” accounts, such as a traditional or Roth IRA, or 401(k), in addition to savings and investing accounts. So, the retirement spending order would seem straightforward, right? Shouldn’t you spend first from the accounts that were specifically established to provide for retirement spending? Not so fast. All of these accounts─both retirement and nonretirement─have their own tax implications and, as we know, taxes are not one of life’s “small stuff” items to be overlooked.

Generally speaking, an investor whose goal is to maximize spending during their lifetime should spend from accounts in the following order²:

Required minimum distributions (RMDs), if applicable. These are the first assets to use for spending because investors 70½ and older are required by law to take RMDs from tax-deferred accounts. The penalties for not taking these distributions are quite steep: 50% of the required distribution amount.

Cash flows on assets held in taxable accounts. Taxable flows─including interest, dividends, and capital gains distributions on assets held in taxable accounts─are next because you already pay taxes on these amounts each year. As a result, it’s better to use these flows to meet spending needs rather than reinvest them and possibly have to sell assets later to meet future spending needs. In the case of capital gains distributions, you may be subject to additional taxes, including much higher-taxed short-term gains if you held the assets for less than one year. You can direct your investment company to automatically send these distributions to your money market or checking account─–thus essentially creating a paycheck for yourself.

Taxable assets. At this point, you will need to start selling assets from either your taxable accounts or retirement accounts. We believe investors should deplete their taxable assets prior to spending from their tax-deferred or tax-free accounts, but for different reasons. Taxable spending should precede tax-deferred spending because swapping the order would accelerate the payment of income taxes and forfeit tax-deferred growth, resulting in lower asset balances and spending. On the other hand, investors should spend from their taxable accounts before spending from their tax-free accounts to maximize the long-term growth of their tax-free accounts and spending. Two things to keep in mind when selling assets: Try to minimize the impact of taxes by selling assets at a loss or minimal gain (if possible), and if selling assets results in your asset allocation getting out of whack, you can rebalance within your tax-advantaged accounts without incurring taxes.³

Tax-advantaged or “retirement” assets. Once you exhaust your taxable portfolio, the decision to spend from tax-deferred or tax-free assets comes down to your tax rate expectations. Generally speaking, you should spend from your tax-deferred accounts when you believe your tax rate will be the lowest. By minimizing the taxes you owe, you can keep a larger share of your assets.

We found that investors who do focus on what may seem like a “small” decision can add up to 70 basis points of average annualized return to their bottom line as compared with an investor who spent from retirement accounts prior to spending from taxable accounts.⁴ Over time, the impact on an investor’s savings can really add up, as seen in the chart below of a hypothetical $100,000 initial portfolio grown at 7.0% and 6.3% (70 bps lower return) over a 30-year retirement horizon.⁵ This example shows that the investor who thought about spending order could have had an additional $80,000 to spend compared with the investor who overlooked this seemingly “small detail.”

Please keep in mind that this order assumes your goal is to maximize lifetime spending and may not be the “preferred” order if your bequest or other estate planning motives supersede maximizing spending during your lifetime. I don’t know about you, but after my 7- and 9-year-old daughters are educated and on their way, I plan on making the most of my retirement years or die trying!

For those of you who feel this process is a bit more than you want to manage, or have estate planning considerations, this is certainly one area where seeking advice can make a lot of sense and may even pay for itself.

In my opinion, by “sweating the small stuff” of spending order, you can live a little larger in retirement!

³ Keep in mind the wash-sale rules. A wash sale occurs when an investor sells a security at a loss and purchases a substantially identical security within 30 days before or after the sale. Therefore, the wash-sale period for any sale at a loss lasts for 61 days (day of sale plus 30 days before and after). To deduct the loss for tax purposes, an investor would need to avoid purchasing a substantially identical security during the wash-sale period. Consult a tax advisor or see IRS Code 1091 for more information.

Colleen Jaconetti

Colleen is a senior retirement strategist in Vanguard Investment Strategy Group. She leads a global team that's responsible for conducting research and providing thought leadership on retirement topics. Colleen specializes in retirement planning, spending, and wealth management strategies. Prior to her current role, Colleen worked as a financial planner in Vanguard's advice department. Colleen earned a B.A. and an M.B.A. from Lehigh University. She is a Certified Financial Planner™ professional and a Certified Public Accountant.

Comments

Richard G. | June 1, 2016 11:37 am

I have a question folkes. What are we considering as a high tax rate?I am sure Vanguards clients cover the whole financial landscape.The clients who have saved a bundle and are staring at millions in their IRA’s,401k’s etc. they know that they are always going to be in the 25-33% tax range from the get go.That’s not even counting their other sources of income.Anything over $400,000/yr is in the 39.6% stratosphere bracket! On the other hand you have the person who has NOT done what Vanguard has encouraged their clients to do.They go into their retirement with a $1500.00/mon. S.S.check and a $99,000.00/IRA to help fund their retirement.Let’s see which camp do I want to be in? I will always take the position of financial strength.I will let Vanguard guide me during my retirement to pay the least possible in taxes but I am not going to lose any sleep over it.In my case I went the traditional 401k/IRA route and I have hidden all of my funds from Uncle Sam for almost 45 years.I have known all along that I was going to have to pay taxes on this money.Guess what he can only tax me ONE year at a time!Vanguard has allowed my wife and I to retire 8 years early and I plan on building my IRA for those years and not worry about the taxes.I sure would like for our company to break into our 4th Trillion under management in 2016. Good Luck to All!

Donald G. | April 6, 2016 8:04 pm

Well Folkes it appears that we are getting into the land of I wished that I had.Everyone can mange a lot better using 20-20 HINDSIGHT.Mr. Bogle has said that no one knows what the market is going to do-IN ADVANCE.I cannot understand why a person who has done a great job of saving their money,invested it wisely over a long working career is complaining about the taxes that you knew was going to be owed from your traditional 401k,IRA.To me this is a much better position to be in than having saved very little and have to live in retirement on a $1500.00/mon S.S.check. because you saved nothing during your working years. I would always rather enter retirement in a position of financial strength as opposed to being slightly above a pauper.This is one of the many things that Vanguard counsels it’s clients to do-Start early,buy the whole market,diversify. Do not put all of your life’s savings in one basket. If you do then you had better “watch that basket”.Great article! Let us try and get to that 4th Trillion in 2016. Good Luck to All.

Les K. | January 2, 2015 4:24 pm

My wife and I are retired and have most of our money in cash( earning very little) . Is it better you us to be in a short term bond fund in this raising interest rate environment? We do not need retirement income .We would love to get enough so our cash keeps up with inflation. Do you have any recommendations that do not involve too much risk? Thank you for your thoughts.

Richard G. | November 25, 2015 4:21 pm

To Les K. Jan 2, 2915 4:24 p.m.Let me suggest that you contact Vanguard and give them your specific financials. They will need to know your ages,how much debt you have and where you are with your monthly income needs. If most of your excess income is in cash then you certainly are getting a very low return on your money. You know of course that when you begin RMD’s Uncle Sam will tell you how much cash that you will have to take out according to the longetivity schedule . Good Luck to you Sir

Dick S. | December 4, 2014 1:42 pm

I appreciation your comments and charts, and they’re helpful in a general way. I have a question about this strategy that doesn’t seem to be addressed, however, other than in the statement that one should try to minimize the income tax effect on retirement withdrawals. Shouldn’t one also take into account the statistical probability that a fairly high percentage of us will have long-term care expenses and higher medical expenses later in life and that these are mostly deductible expenses that will exceed the 10% minimum in many cases? The result could be lower taxable income in those years which would present good offset opportunities for tapping into tax-deferred accounts, if there is anything left in them. At least that’s how it appears to me. What do you think?

David G. | November 23, 2014 4:54 pm

Mark S. raises a very good issue to have other experts comment on. From my vantage point the health care cost issue is one that can’t be ignored by the long term plan. If, for example, RMD activity is reinvested on the taxable side of the ledger this will create more recurring income (we hope) in addition to the one time impact caused by the RMD. RMD activity year over year may well apply unavoidable pressure to the trigger levels for higher medical insurance premiums in addition to higher taxes. Charitable contributions can help with the tax issue but not the insurance cost issue. Depending on the income change insurance cost increase may become permanent. The plan needs to model different RMD amounts over time with their tax and insurance impacts. I have tried to do this. It is an interesting exercise that needs refinement but it can show you what to expect.

Hi, Glenn. Yes, dividends received and used for spending would count toward the 4%. For example, if 4% equates to $40,000 per year in portfolio spending and you receive $10,000 in dividends on assets held in taxable accounts, you would then only take an additional $30,000 out of the portfolio. And, yes, you would need to tell Vanguard which assets to sell to obtain the additional $30,000 to meet your spending needs. Thanks for the questions!

Donald G. | December 20, 2015 11:23 pm

To Ms. Jaconetti I always appreciate your articles. I have a question regarding your statement in reply to Glen W.He asked would dividends be counted in the 4%
RMD withdrawal amount from his IRA?You stated that it would count if he were to withdraw $10,000 from his taxable account then he would only need to take another $30,000 from his IRA to satisfy the 4% annual withdrawal amount.I will be taking RMD’s starting in 2018 and I thought only money in your tax-deferred account was subject to IRA withdrawals.I had the understanding that your whole $40,000 has to come out of the IRA.Hopefully I have not misinterpreted what you meant.If I have done so I apologize to you.Please continue with your great articles and Merry Christmas to all!

Donald P. | November 3, 2014 4:49 pm

This is generally a good article and your spending order diagram is largely correct. However, it ignores the progressive nature of the US tax code. Because of the progressive nature of the tax code (higher incomes are taxed at higher marginal tax rates) it is important to avoid having some years with large taxable income and some years with small taxable income. It is much better to manage your yearly taxable income so that it is nearly constant year to year. Otherwise, your exemptions, deductions, and low tax brackets are “wasted” in the years with low taxable income and the income that would have been untaxed or taxed at low rates would instead be taxed at a high rate in the years with high taxable income.

If someone followed your spending diagram exactly he might find himself with low taxable income in the years he is spending from his taxable portfolio (assuming low or moderate unrealized capital gains) and from his tax-free accounts. He will have high taxable income in the years he spends from his tax deferred accounts. He would be much better off to spend from a mix of his taxable, tax deferred, and tax free accounts each year so as to keep his taxable income nearly constant, thereby minimizing the income that is pushed into the highest tax brackets.

Alan S. | October 26, 2014 9:46 pm

Regarding the first comment above, a paraphrase might be, “Your simple model/narrative isn’t flexible/detailed enough to account for my own situation XYZ.” As a software engineer (recently retired) I learned that “abstraction is representing the whole by only some parts,” and that we all love to find simplifying narratives even if they are wrong. But even when correct they are necessarily incomplete. So even a solid simple narrative or guideline must be flexibly followed with variations for one’s own particular circumstances. Me for example, I’ve started and intend to take substantial (taxable but not penalized) withdrawals from my large traditional IRA (at Vanguard naturally) for many years until RMDs start, to knock down their tax impact later. Note well that withdrawals, in MY simplifying narrative, include Roth conversions.

Paul D. | October 26, 2014 2:15 pm

Paul S. makes an excellent point about not looking at just taxes relative to retirement. Unfortunately, none of us can see the future and few are well prepared for what it brings.

There is also an excellent article in Saturdays (10/25/14) WSJ about “Piecing Together an Estate Plan” where the author (Laura Sanders) discusses the latest estate tax exclusion, portability and trusts. Apparently, some older tax saving trust holders could wind up paying higher taxes as a result of portability and the ‘step-up’ in asset basis resulting in the trust holders demise. Also, it seems that assets held in a traditional IRA do not get a step up in basis because they are in a tax deferred account (which doesn’t benefit capital gains taxes). So that 2500 shares of highly appreciated stock held in my IRA will be subject to being taxed at 23.8% when it is sold….where as it would have had no capital gains tax (due to the step up) if I had just left the stock to my heirs.

All the more reason to have your portfolio ‘fine tuned’ by a Vanguard CFP. It would also appear that there is much more “small stuff” todays investors need to sweat to be successful and make money. Also, perhaps for some of us anyway, it may be a good time to start thinking about turning the estate management over to the pros at Vanguard.

Paul S. | October 24, 2014 11:33 am

I followed this advice; I now regret it. I did not look forward early enough to realize that once RMDs and Social Security were added to my pension that I would have a relatively large ‘uncontrolled’ income–I would get it every year and could not make adjustments once the payments began.
Then Medicare adopted step-function surcharges that increased their rates significantly if I went $1 over a $85K single MAGI. The $85K point is not adjusted for inflation.
So when all these payments add together, I will be over $85K (much of which I won’t spend), but not by as much as my Medicare rates will increase–I will walk away with less than $85K.
Of course, there was no way to see in 2002 that this situation would develop. However, I would have been better off if I’d spent out of my IRA the last 12 years, rather than depleting my ‘real world’ assets. That would have lessened my RMD enough that I would be under the $85K limit.
I suppose my advice would be to strive for a balance between regular and Roth IRA funds–and between deferred and non-deferred funds. Don’t look just at taxes; be aware of other fees that might arise at specific income points and try to keep control of your future cash flows to avoid negative results.

Mark S. | November 17, 2014 7:27 pm

I have been waiting for an “educated” perspective on MAGI Management. I appreciate your thoughts. For retirees like me, funding healthcare for several years prior to Medicare, through the ACA, means balancing pre and post-tax sources of income and assets. Maintaining a MAGI below certain thresholds can have a significant impact on your healthcare costs and is not considered in most financial planning. For me, this means running an SEP-401K this year to avoid ’14 consulting income in my MAGI. It also means managing gains and losses to stay within the cap. Even one year of full ACA vs. a subsidized rate is money never to be recovered. I am still looking for a guru to weigh in. Thx

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For more information about Vanguard funds, visit vanguard.com or call 877-662-7447 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss.

Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. Stocks of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.

All investing is subject to risk, including the possible loss of the money you invest.